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September 15, 2006 4:34 pm

Arne Alsin: The triumphant return of the stock

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Stocks are a far more compelling investment today than bonds. To understand why, let’s compare investing in a 4.8 per cent 10-year treasury bond with investing in the stocks of these companies: Citigroup, General Electric and Home Depot. (I own shares in Home Depot).

It is easy enough to compare the 4.8 per cent bond yield with the dividend yield of these companies. The 1.8 per cent dividend yield of Home Depot is modest compared with the bond yield. But the dividend yields of Citigroup, at 4.1 per cent, and GE, at 3 per cent, are quite competitive with the 4.8 per cent bond yield on an after-tax basis (dividends are taxed at a much lower rate of 15 per cent).

One of the best ways to compare bonds with stocks is to contrast bond yields with the “earnings yields” of stocks. An earnings yield is generated by dividing earnings into the stock price. Since Citigroup is trading at about $48 a share and will generate $4 a share in earnings this year, the earnings yield is 8 per cent ($4 divided by $48). In addition to Citigroup, the earnings yield of GE is 7 per cent and Home Depot is
9 per cent. It is interesting that these earnings yields understate the potential return from these stocks, as I explain below.

Earnings grow: If you invest in a 10-year treasury bond today, your yield in the 10th year will be the same as the yield in the first year: 4.8 per cent. The earnings for the above-named companies will not be static. It is highly likely that their earnings will grow over time. When Warren Buffett began buying Coca-Cola in 1988, the company’s earnings yield was 6.5 per cent. That’s not an impressive earnings yield when compared with the treasury yield at the time, at 9 per cent. But Buffett’s tenfold return in Coke stock since 1988 is quite impressive. And it’s due almost entirely to earnings growth.

The reinvestment advantage of stocks: It’s easy for investors to focus on dividends and ignore earnings yields. That’s because dividends represent the portion of earnings that investors actually get their hands on. In terms of real wealth creation, though, nothing is as important as undistributed earnings.

While an investor in a 4.8 per cent bond has to figure out how to deploy their income, stock investors delegate this “worry” to company management. Based on each company’s long-term record, it is reasonable for investors in the shares of Citigroup, GE and Home Depot to expect an 18-22 per cent annual compounded return on undistributed earnings.

While Buffett’s purchase of Coke at a 6.5 per cent earnings yield looks questionable when compared with a 9 per cent treasury yield, it makes sense when viewed in the context of Coke’s rate of return on undistributed earnings, a rate that has averaged more than 30 per cent a year.

While investors should look closely at the current earnings yields, the rate at which undistributed earnings compound is just as important.

The tax advantage of stocks: While investors in bonds pay taxes on their interest income every year, long-term investors in stocks are able to avoid or defer a lot of tax. For instance, let’s assume you buy shares in Home Depot with the intention of holding the stock for at least five years. The only tax you’ll pay is the 15 per cent rate on dividends. You don’t owe any tax on undistributed earnings.

With the stock now about $34, Home Depot should be worth $60 or more in five years’ time, assuming the price/earnings multiple stays at 12 times earnings. As a buyer of Home Depot stock, you owe no tax on this prospective $26 gain until you sell your shares. And, when the shares are sold, tax is levied at long-term capital gains rates, a much lower tax rate for most investors than the tax rate on interest income from bonds.

It’s reasonable for investors in Home Depot to expect a “kicker” in the form of a higher P/E ratio, perhaps up to 15 times earnings. The present P/E multiple is too low, given the company’s growth prospects and solid balance sheet. A multiple of 15 times earnings implies a Home Depot stock price of $75 a share in five years’ time, more than double the current quote.

So what does this mean for the choice between bonds and stocks? With premier companies generating earnings yields that are much higher than the 4.8 per cent 10-year treasury bond, the stock and bond markets seem to be out of synch. Some sort of adjustment is needed. Either treasury yields are too low or earnings yields of blue-chip companies are too high.

Whether inflation escalates or stays at benign levels, stocks offer a better risk/reward trade-off than bonds. If inflation surges to 6 per cent, for example, investors in companies with 7-9 per cent earnings yields have more inflation protection than bond investors with 4.8 per cent fixed yields. If inflation stays at benign levels, long-term stock investors have much higher return potential than bond investors.

Arne Alsin is a portfolio manager for Alsin Capital and the Turnaround Fund
arne@alsincapital.com

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